Points to ponder before you bet big on small caps! - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Points to ponder before you bet big on small caps! 

A  A  A
In this issue:
» India's GDP growth likely to hit roadblock
» Investors should apply caution while investing in banking stocks
» Does economic data reflect true state of Indian economy
» IT companies losing out on client retention
» ...and more!

Indian stock markets have witnessed a classic run in the recent times despite a weak show on the macroeconomic front. The benchmark indices are trading at all time highs on the back of rupee recovery, FII inflow and expectations of a business friendly Government post elections. Among the indices, the one that has been galloping is the BSE Small cap index. Unlike last year when small cap stocks were out of favor, the small cap index is currently commanding a PE of 115 times against a PE of around 17 times trailing 12 month earnings for Sensex. Before investors assume that the astronomical valuations of the smallcap index can be credited to improvement in fundamentals and buoyant market conditions; let us assure you that there is more to it. And investors have sufficient reason to ponder over some aspects before betting big on small cap stocks.

First of all, the steep rise in the price to earnings multiple is due to sharp fall in trailing twelve month earnings of small cap stocks. So unlike their largecap peers (reflected by the Sensex) the earnings growth of smallcap stocks has not kept pace with the improvement in valuations. Hence the ratio has bloated.

Moreover, unlike the large cap companies that operate in a mature business environment and have limited scope for growth and upside in valuations; small cap stocks are relatively unidentified. As such, if caught in the early stages of the growth cycle, small cap stocks can offer above average growth and returns. Currently, the expectations of an economic turnaround are running high. As such, the market is expecting small caps to outperform the larger peers leading to premium valuations. However, the recent run up in the price of smallcap stocks has also made them susceptible to a correction.

Investors need to remain wary about the management quality of smaller companies. Look at the past track record and management efficiency. The returns ratios, promoters' stake, pledging and leverage ratios are some of the quantitative ways to judge the management. While this can help one screen out stocks that do not qualify, it can hardly be the sole criteria for choosing a stock.

Remember, past performance is no guarantee of future success. Hence, equally important is the business model. Unless the company has a unique and robust business model, no matter how promising the financials seem, it is unlikely that the company will be able to scale up the business and sustain the growth in the long term. In short, it is important to look for businesses with a moat. It could be in the form of licenses, access to raw materials, sales tie ups etc.

One thing that investors must make sure is to use a bottom up approach in selecting small stocks. While small caps have huge growth potential, there is a flip side to it. The small cap stocks are much less resilient than the larger peers to an adverse macro economic cycle. When economic cycle takes an adverse turn, these stocks might be the first to get battered as investors flock to the safety of blue chips. This is especially the case with the companies that have high leverage or have high promoter pledging.

The risks associated with small cap stocks such as low liquidity, high volatility and susceptibility to economic cycles are huge. These risks cannot be totally eliminated. However, they can be minimized with an intelligent portfolio diversification. While the allocation will depend upon return expectations and risk tolerance of investors, we believe that not more than 10% of one's portfolio should be allocated to small caps. Further, the investment in an individual stock should not exceed 2%-3%. Since small cap stocks are thinly traded, this will ensure that in a bad market scenario, the investors are not forced to offload their stake in good small cap stocks at steep discounts in case they need liquidity.

Thus investors would do well to be extremely selective and invest in only those smallcap stocks that have negligible downside risks in fundamentals and valuations.

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02:00  Chart of the day
After registering a hat trick of successive higher growth rate in the last 3 five year plans, growth in the current plan is likely to hit a road block. While the planning commission initially projected a growth rate of 8% in 12th five year plan, reaching even 6.5% could be a challenge now. That's because the growth in the first two years of the current five year plan has been muted. And this is likely to drag the overall performance for the current plan period. As such, the initial target of 8% growth seems illusive.

Policy paralysis, red tapism and environmental issues have been the main reasons as to why growth has suffered in the first two years of the current plan period. However, with a new business friendly government expected to assume power at the centre soon, growth may pick up in the next 3 years of the current plan period. But it may be wishful thinking to assume that the bounce back will be sharp and steep. The fact is that Indian economy is in complete mess. Inflation is showing no signs of relenting. In addition to that, we now have El Nino concerns creeping in. Global economy is not out of the woods either. Thus, restoring the 8%-9% growth as seen in the past will be a difficult task and a long drawn process even if the new government shows desired intent and puts decision making in place.

Forget 8%! GDP growth of 6.5% remains a challenge
Note : No five year plans for 1990 - 1992
1980 - 85 means April 1980 to March 1985. This applies to all periods
* As per Planning Commission's projections

The rally in Indian stock markets over the past few months has been backed by buoyant sentiments. The anticipation of reforms from the new government led to stocks across sectors fetching premium valuations. And the biggest gainers have been the beaten down stocks from the infrastructure and banking sectors. Needless to say that these sectors are expected to be the earliest ones to reflect any signs of recovery in the economy. And hence their valuations got re-rated. The banking sector also got a shot in the arm with the RBI awarding two banking licenses and promising more in the future. As a result investors chose to ignore the NPA risks and bought them at a premium. But unlike the stocks in some other sectors that have reported better earnings growth in past few quarters, can banks claim any improvement in fundamentals? Barring few private sector entities, most banks in the PSU and private sector space continue to be under the pressure of providing for NPAs. Moreover unlike non banking entities, banks cannot be valued based on quarterly improvement in EPS. For the same is influenced largely by changes in interest rates rather than the banks' own efficiency. Hence investors would do well to tread with caution while investing in banking stocks.

Have the industrial production and inflation data released been reflecting the true state of the Indian economy? Most probably not. And that is why a high-level government committee has suggested changes to the same. Firstly, it has been proposed that there should be a change in the base year taken for consideration. Right now, for both the indices, the base year stands at 2004-05. The suggestion is to change this initially to 2009-10 and then to 2011-12. The reason for selecting 2009-10 as a base year was because it was a relatively normal year when the economy grew by 8.6% and there was no drought-like situation. The other proposal is to increase the number of items constituting the indices. The idea is to make the indices more representative of the current product trends and not of an obsolete basket of products. We believe that this is a step in the right direction. Economic data being released becomes an important basis for many key policy decisions. And thus it only makes sense that the data being considered is relevant to today's times and not to the past.

Not receiving environmental clearances on time has been a big drag on the power sector. However, this is likely to become less of a headache for a certain segment of the generators; those that would be developing super-critical power plants. As reported by the Financial Express, the government is considering doing away with the condition of giving environment clearances for such plants only if their captive coals mines have already got forest and environment clearances. Such a move is likely to give a fillip to the construction activity of plant capacities of as much as 40,000 mega watts (MW). This facility was extended to ultra mega power projects earlier and now is likely to be extended to plants using super-critical technology. How much of an effect will this have on the engineering and construction sector? Well... it would be difficult to say, but it is definitely a step that was required to boost projects and construction activity.

In the quest for maintaining growth and profits; Indian IT companies seem to be losing the race when it comes to client retention. Although these companies have added several clients, most of them have been unable to grow their active client base in terms of getting more business from them. This is primarily because the leakage in the client base is not adequately compensated by new and larger deal wins. As per a business standard feature, amongst the top IT companies, only TCS seems to have allayed the fears of client loss by expanding its active client base in FY14. However, Infosys and Wipro have been able to add only handful of clients.

Vendor consolidation, sticky accounts and increase in competition from smaller offshore players are some of the key reasons for the slowdown in client growth. Also, India is no longer as cost-effective as it was earlier as an IT hub. Due to inflation, salaries of employees which are the most substantial cost of an IT firm have risen. Also, renegotiation of deals is on the rise due to rupee depreciation as well as new competition offering services at lower rates. All said and done, Indian IT giants have years of experience in the outsourcing business and barring few hiccups, they have stood the test of time on more than one occasion. Therefore, it will be difficult for new entrants to replicate the expertise of these companies. However, complacency in this cut throat competitive environment could be fatal. Therefore, IT companies should work towards retaining clients through constant innovation, offering better terms and also working on cost effective measures so that re-negotiation of contracts does not pinch their pockets.

In the meanwhile, the Indian stock markets continued to trade in the green. At the time of writing, the benchmark BSE-Sensex was up by 154 points (+0.7%). Majority of sectoral indices led by energy and metal were trading strong. However pharma and IT were among a few indices trading in the red. Most of the Asian stock markets were trading in the red with Hong Kong and Malaysia being the major losers. Markets in China and Indonesia were trading marginally positive. European markets opened the day on a negative note.

04:50  Today's investing mantra
"The key to making money in stocks is not to get scared out of them." - Peter Lynch
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